JLB Corporation is attempting to determine whether to lease or purchase research equipment. The firm is in the 40% tax bracket, and its after tax cost of debt is currently 8%. The terms of the lease and of the purchase are as follows:
Lease Annual end-of-year lease payments of $25,200 are required over the 3-year life of the lease. All maintenance costs will be paid by the lessor; insurance and other costs will be borne by the lessee. The lessee will exercise its option to purchase the asset for $5,000 at termination of the lease.
Purchase The research equipment, costing $60,000, can be financed entirely with a 14% loan requiring annual end-of-year payments of $25,844 for 3 years. The firm in this case will depreciate the equipment under MACRS using a 3-year recovery period. (See Table 4.2 on page 117 for the applicable depreciation percentages.) The firm will pay $1,800 per year for a service contract that covers all maintenance costs; insurance and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its 3-year recovery period.
a. Calculate the after-tax cash outflows associated with each alternative.
b. Calculate the present value of each cash outflow stream, using the after-tax cost of debt.
c. Which alternative-lease or purchase-would you recommend? Why?